'Regression to the mean'…sounds more complicated than it is.
To ‘Regress’ is to return to a former or less extreme state. ‘Mean’ is another word for average. For example, kick 44 goals in a 22 game season and your average is 2 goals per game. (44 goals divided by the number of games played 22 = average of 2).
Most things regress or revert to the mean. This is especially so when it comes to financial markets and the performance of AFL clubs over a period of time. Certain clubs outperform for a period of time and then drift back to their average performance levels. Certain clubs average finals each season (for example the Sydney Swans), others average a position on the ladder somewhere between 6th-12th.
There are, however, some years/seasons when financial markets and certain AFL clubs achieve sustainable above average success. Almost every time this occurs, the exceptional performance can be partially explained by event(s) that may be described as "extraordinary", that can distort equilibrium. What are examples of AFL related "extraordinary" events? Salary cap concessions, draft pick concessions, father-son-rule and new entrants into the competition.
In the early 2000’s, the Brisbane Lions participated in 4 consecutive grand finals, winning a treble 2001-2003. It’s fair to say that some presidents of other AFL clubs, had more to say on the issue than others, but the general consensus was that the extended salary cap concessions (extraordinary situation) that the Lions were afforded was the main reason for their success. In 2006, those salary cap concessions were scrapped and the Lions have hardly featured in the finals since.
Some might argue that a lot, but not all, of Geelong’s success between 2007-2010 came from obtaining selecting father-son recruits for virtually zero cost (the AFL subsequently changed the rules) and others are putting Hawthorn’s success down to the fact that two new teams were entering the competition and the draft was compromised, meaning the strong teams before the new teams entered remained strong because the young talent went to the new franchises, and the struggling team struggled until equilibrium was restored. The incorporation of free agency has also played a part.
In financial markets, the extraordinary event, also referred to as a ‘Black Swan’, was the global financial crisis of 2007. To avoid a depression, central banks around the world printed money which caused ‘cash rates’, also incorrectly referred to as ‘interest rates’, to fall dramatically, well below their historical average levels. So much so, that in Australia, the cash rate has never been lower.
It’s something you already know, but interest rates and property values have an inverse relationship. A low interest rate environment tends to encourage higher property values, and vis versa. The chart above and below proves this thesis. Concentrate your attention on the last two columns on the right in the below table, and specifically the yellow highlighted cells.
As you can see, under ‘Australian Listed Property’ (ALP) and ‘Listed Property’, (LP) these two asset classes crushed it. Double digit growth every year for the past 5 years, and most of those figures have a ‘2’ in front of it. Last year, ALP returned nearly 25% and LP 20.4%, yet their average return since 1991 is 10.9% and 11.2% respectively. The phenomenal growth achieved by these asset classes has come as a result of a result of lower interest rates, and the only question investors need answering is, when will interest rates normalize and regress to their mean (up) and how quickly will the property sector respond (down) and at what rate?
Will property values across the board do a Brisbane Lions? Crash through their mean and sit well below it for 10 years. Or will they do a Geelong? an orderly reversion to an elevated mean. In either scenario, with the average return of both asset classes sitting a touch above 10%, it’s a double digit fall from here when it happens.
The alternative (continuation of double digit growth) is the equivalent to Hawthorn winning 7 consecutive Premierships (property doubling AGAIN! in 5 years) - some food for thought.